Supplementary Submission to the Financial System Inquiry 2. Financial Stability

The Bank supports the Interim Report's focus on mitigating systemic risk and improving the resilience of the financial system. The Bank's initial submission examined the issues surrounding these objectives in detail, devoting chapters to discussing the regulatory response to the global financial crisis and the sources and management of systemic risk in Australia (RBA 2014, pp 43–112). Some of the options raised in the Interim Report are considered below.

2.1 The Council of Financial Regulators

The Reserve Bank endorses the observation that Australia's regulatory coordination mechanisms have been effective. As demonstrated during the financial crisis, the CFR is an important vehicle for coordination and crisis management. The Reserve Bank and other CFR members believe that the current informal arrangements have underpinned its success as a vehicle for cooperation.

The Interim Report notes that the current arrangements have proven to be a flexible, low-cost approach to fostering collaboration and frank discussion among regulators. While acknowledging the good performance, the Report also includes the option of formalising the role of the CFR within statute, as has been adopted in some other jurisdictions in response to the crisis. In doing so, the Report acknowledged that ‘legislation cannot be relied on to promote a culture of cooperation’ and that formalising CFR powers in statute could engender confusion with agencies' existing mandates (FSI 2014, p 3–119). As noted in the Bank's initial submission, the potential benefits of greater formalisation of coordination arrangements should not be overstated, and these arrangements are too new in many advanced jurisdictions to judge their effectiveness (RBA 2014, p 67).

The lack of formal legislation related to cooperative arrangements should not be taken to imply an absence of structure and rigour in deliberative processes. The CFR agencies have several standing working groups charged with progressing initiatives such as reforms to crisis management powers, financial market infrastructure oversight and cross-border coordination. These working groups operate according to responsibilities agreed by the CFR and are accountable to it.

Another policy option raised in the Interim Report is to expand the CFR membership to include agencies such as the ACCC, the Australian Taxation Office and AUSTRAC. The Reserve Bank notes that the current arrangements provide for other agencies to attend as required to discuss specific topics of mutual interest and arguably is the most efficient use of regulators' resources. This engagement can be stepped up if needed without any diminution of the core CFR agencies' focus on their key mandates.

The Report also raises the prospect of greater reporting by the CFR to enhance transparency. Considerable effort is already made to publicise the work of the CFR, through the dedicated website for the CFR launched in February 2013, alongside regular reporting on the CFR activities in the Reserve Bank's Financial Stability Review. An additional option put forward in the Interim Report is for the CFR to produce an annual report. The CFR used to publish an annual report but ceased doing so in 2003, ahead of the commencement of publication of the Bank's inaugural Financial Stability Review. If there is demand for more stand-alone reporting this could be met by the CFR producing an annual update on CFR activities. Another option would be for the Bank to provide for more segmented reporting on CFR activities in the Financial Stability Review.

2.2 The Prudential Perimeter

The Interim Report notes that, on rare occasions, it may be necessary to respond to risks outside the prudential regulatory perimeter. One option put forward is to enable the relevant Minister to designate institutions or activities to be brought into APRA's purview on systemic risk grounds, on advice from either the Reserve Bank or the CFR. Such powers are a relatively recent innovation, forming part of the package of reforms to the regulatory architecture in countries relatively heavily affected by the crisis such as the United States and the United Kingdom.

The Bank considers that current arrangements in this area are working well. The CFR, as laid out in its Charter, is already established as a forum to ensure that there are appropriate coordination arrangements for responding to actual or potential instances of financial instability. Part of this role includes advising the government on the adequacy of Australia's financial system regulatory arrangements, including the regulatory perimeter. In Australia, the non-prudentially regulated sector accounts for a much smaller share of the financial system than is the case in the United States and the United Kingdom. The CFR regularly reviews developments in financial markets and financial institutions. In addition to this, the Bank provides an annual report to the CFR regarding developments in the non-prudentially regulated sectors (FSB 2012, p 26). CFR members therefore regularly consider potential risks arising from these sectors, and, if necessary, potential action by member agencies within their areas of responsibilities. To date, these processes have proven adequate to monitor and manage systemic risks. That said, in the event that a systemic risk did arise that could not be handled within the mandate of the regulators, a mechanism to adjust the regulatory perimeter could potentially improve the response time in addressing the risk. As with macroprudential tools, the Bank and other CFR agencies will continue to closely monitor developments in the few countries that have adopted this approach, including processes to promote accountability.

2.3 Macroprudential Policy

The Bank concurs with the Interim Report's caution regarding unproven macroprudential tools. The Bank and the other CFR agencies view macroprudential policy as being subsumed within the broader financial stability policy framework in Australia. The Interim Report notes the existing framework where APRA, in consultation with the Bank and other CFR agencies, is responsible for administering prudential regulation.

Consistent with its existing mandate to promote financial stability, APRA has adapted its prudential intensity in light of developments in systemic risk. For example, following signs of increased risk appetite in the mortgage market, APRA recently surveyed mortgage underwriting standards, released guidance on managing mortgage risk, and asked the major banks to specify how they are monitoring lending standards and the ensuing risks to the economy.

As noted in the Bank's initial submission, tools like loan-to-valuation ratio and debt-servicing ratio limits on mortgages have only recently begun to be used in developed countries. It is still too early to judge their effectiveness with the available evidence so far mixed (RBA 2014, p 52); the effects of particular initiatives are not easily disentangled from those of other policy settings, including changes in monetary policy. APRA already has the powers to implement these tools if it was decided they would be beneficial (APRA 2014, p 59). The Bank is not attracted to arrangements whereby prudential policy setting is spread across multiple agencies or groups of agencies. Australian agencies will continue to closely monitor how these tools perform overseas.

2.4 Stress Testing

The Interim Report seeks views on whether Australian regulators should make greater use of stress testing. Since a recommendation from the International Monetary Fund in 2012, APRA has increased available resources and begun a regular industry stress-testing cycle using a range of scenarios, across differing sectors (IMF 2012). The Bank has increased its engagement with APRA's stress-testing processes. The Bank has also surveyed stress testing internationally, and is continuing to build on this knowledge through its own modelling (Bilston and Rodgers 2013). Even so, stress testing will properly remain only one aspect of the Bank's financial stability analysis. Current stress-testing practice has a number of shortcomings, not least that deriving the outcomes from different scenarios necessarily involves extrapolating beyond historical experience (Borio, Drehmann and Tsatsaronis 2012).

2.5 Financial Claims Scheme

The Interim Report called for views on whether the Financial Claims Scheme (FCS) should be modified. The FCS provides protection and timely payout to depositors (up to $250,000) in the unlikely event of a failure of an ADI, and provides compensation to eligible policyholders against a failed general insurer. Alongside the depositor preference regime in Australia, the FCS promotes confidence among depositors during times of stress, improving the resilience of the financial system and bolstering economic activity. The Bank views the availability of a safe financial product promising full payout – that is, a deposit – as being in the public interest, and believes that private sector providers of such a product have responsibilities and should bear appropriate costs to ensure their promises are kept.

The Bank supports the March 2013 CFR recommendation to switch to an ex-ante funding model for the FCS (RBA 2014, p 61). Such a model, which is now common among depositor protection schemes internationally, is in line with the principle of users paying for the benefit provided. It would also be consistent with IMF recommendations that Australia re-evaluate the merits of an ex-ante funding model (IMF 2012). The Bank also supports the CFR's proposal to broaden the allowable uses of FCS funds, which may reduce the overall costs that are imposed on deposit-taking institutions and the broader economy.

The Bank does not consider lowering the threshold for depositor protection under the FCS to be a high priority. The government set the current $250,000 FCS threshold based on advice by CFR agencies after weighing the merits of higher thresholds – which may impede market discipline – and lower thresholds, which may not adequately bolster confidence in times of stress. In so doing, it drew a line between those depositors considered to be in need of protection and sophisticated depositors, who were deemed to be more capable of assessing and managing risk. Competition was another consideration; for instance, a lower limit may lessen the ability of smaller ADIs to attract deposits. The $250,000 threshold also aligns with APRA's existing threshold for the distinction between retail and wholesale deposit-taking by ADIs.

As noted in the Interim Report, the FCS has imposed compliance costs on ADIs, though this is appropriate given ADIs' responsibilities as providers of a financial product promising full payout on demand. The financial crisis showed the importance of promoting depositor confidence in the financial system, and the role that deposit insurance has in maintaining that confidence.